Monday, August 13, 2012

Building a Better Dow

The following post, written jointly with Debraj Ray, is based on our recent note proposing a change in the method for computing the Dow.

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With a market capitalization approaching 600 billion, Apple is currently
the largest publicly traded company in the world. The previous
title-holder, Exxon Mobil, now stands far behind at 400 billion. But
Apple is not a component of the Dow Jones Industrial Average. Nor is
Google, with a higher valuation than all but a handful of firms in the
index. Meanwhile, firms with less than a tenth of Apple's market
capitalization, including Alcoa and Hewlett-Packard, continue to be
included.

The exclusion of firms like Apple and Google would appear to undermine
the stated purpose of the index, which is "to provide a clear,
straightforward view of the stock market and, by extension, the U.S.
economy." But there are good reasons for such seemingly arbitrary
omissions. The Dow is a price-weighted index, and the average price of
its thirty components is currently around $58. Both Apple and Google
have share prices in excess of $600, and their inclusion would cause
day-to-day changes in the index to be driven largely by the behavior of
these two securities. For instance, their combined weight in the Dow
would be about 43% if they were to replace Alcoa and Travelers, which
are the two current components with the lowest valuations. Furthermore,
the index would become considerably more volatile even if the included
stocks were individually no more volatile than those they replace. As John Presbo, chairman of the index oversight committee, has observed, such heavy dependence of the index on one or two stocks would "hamper
its ability to accurately reflect the broader market."

Indeed, price-weighting is decidedly an odd methodology. IBM has a
smaller market capitalization than Microsoft, but a substantially higher
share price. Under current conditions, a 1% change in the price of IBM
has an effect on the index that is almost seven times as great as a 1%
change in the price of Microsoft. In fact, IBM's weight in the index is
above 11%, although its valuation is less than 6% of the total among Dow
components.

This issue does not arise with value-weighted indexes such as the S&P
500. But as Prestbo and others have pointed out, the Dow provides an
uninterrupted picture of stock market movements dating back to 1896. An
abrupt switch to value weighting would introduce a methodological
discontinuity that would "essentially obliterate this history."
Attention has therefore been focused on the desirability of a stock
split, which would reduce Apple's share price to a level that could be
accommodated by the questionable methodology of the Dow.

But an abrupt switch to a value weighting or the flawed artifice of a
stock split are not the only available alternatives. In a recent paper we propose a modification
that largely preserves the historical integrity of the Dow time series,
while allowing for the inclusion of securities regardless of their
market price. Our modified index also leads to a smooth and gradual
transition, as incumbent stocks are replaced, to a fully value-weighted
index in the long run.

The proposed index is composed of two subindices, one price-weighted to
respect the internal structure of the Dow, and the other value-weighted
to apply to new entrants. The index has two parameters, both of which
are adjusted whenever a substitution is made. One of these maintains
continuity in the value of the index, while the other ensures that the
two subindices are weighted in proportion to their respective market
capitalizations. Stock splits require a change in parameters (as in the
case of the current Dow divisor) but only if the split occurs for a firm
in the price-weighted subindex.

Once all incumbent firms are replaced, the result will be a fully
value-weighted index. In practice this could take several decades, as
some incumbent firms are likely to be remain components far into the
future. But firms in the price-weighted component of the index that
happen to have weights roughly commensurate with their market
capitalization can be transferred with no loss of continuity to the
value-weighted component. This procedure, which we call bridging, can
accelerate the transition to a value-weighted index with minimal
short-term disruption. Currently Coca Cola and Disney are prime
candidates for bridging.

Under our proposed index, Apple would enter with a weight of less than
13% if it were to replace Alcoa. This is scarcely more than the weight
currently associated with IBM, a substantially smaller company. Adding
Google (in place of HP or Travelers) would further lower the weight of
Apple since the total market capitalization of Dow components would
rise. This is a relatively modest change that, we believe, would
simultaneously serve the desirable goals of methodological continuity
and market representativeness.